Is China Experiencing Hot Money Outflows?

The market (or at least that part of the market that obsesses over balance of payment flows) has been swept with rumors today that foreign exchange reserves were down in January by $30 billion. My experience with these sorts of rumors is that they tend to be fairly accurate, and I suspect they will soon be confirmed.

If true, what does this imply about hot money flows? The PBoC’s accounts have been more opaque than ever and it is extremely difficult to figure out what is really happening, but let me give try at least to bracket the range of outcomes.

China’s trade surplus in January was $39.1 billion. It probably earned another $6-7 billion in interest income plus the reported $7.5 billion in FDI. This means that absent other effects reserves should have risen in January by $52 to $54 billion.

But there were other effects. China holds part of its reserves in currencies other than the dollar, and these declined in dollar terms January (the dollar appreciated). The total loss here may be around $30-40 billion. That means that absent other effects reserves should have risen by at $15-20 billion. If reserves in fact declined by $30 billion, it would indicate at least $40-50 billion in unexplained outflows. Is this all hot money?

Brad Setser recently wrote a widely-read entry in his blog in reference to an article by Jamil Anderlini of the Financial Times about SAFE investments in equity markets that may have lost them $80 billion or more. If this is true, and it seems plausible, some of those losses may have occurred recently, although since the most vicious equity markets were last year, very little of that loss should have occurred in January – and it is anyway an open question whether the PBoC would value these investments at book or at market. Perhaps a small part of the unexplained $40-50 billion represents equity losses, but this cannot explain much of it.

We also know that China has stepped up its purchase of foreign commodities, either directly (which would have shown up already in the trade numbers) or indirectly via investments in commodity producers. The latter would have caused “unexplained” dollar outflows from the PBoC. It is not clear that much, if any, of this happened in January, but perhaps some of the outflow represents new outward investment of this sort. We don’t know.

Against that there is the question of whether December’s 150 basis point reduction in minimum reserves represents a reversal of dollar assets held at the central bank by commercial banks (remember that earlier increases in minimum reserves in 2007 and 2008 had been redenominated into dollars, and so their reduction should have reversed that process). If it did, and this would consist of about $30-40 billion, it would actually increase the unexplained amount. For the sake of conservatism, let’s assume that this hasn’t happened. We should know when the PBoC release its balance sheet numbers if the “Other dollar assets” account changed significantly.

Where does that leave us? There are about $40-50 billion in unexplained outflows and however you look at it there it is hard to believe that we haven’t seen at least $20-30 billion of hot money outflows in January. From my many years experience in developing markets I should say that the informational content of hot money flows is often wider than many people at first think. Much of the discussion about whether Chinese businessmen are bringing in or taking out money hinges on their perception of whether or not the currency will appreciate or depreciate (and in spite of the popular view of evil foreign speculators masterminding the flows, the truth is that the vast majority of this money is likely to be controlled by local businessmen).

But I would argue that usually a much bigger driver of hot money flows is the local perception of risk in the country experiencing the flows. If hot money is flowing out of China, it could be because local business owners believe the currency will depreciate, but I think it is more likely that the flows represent their concern that local investment opportunities – for example their businesses – have become increasingly risky and uncertain. Hot money flows tell us at least as much about risk perceptions as they do about profit opportunities, especially when the world is in trouble.

By the way, this exercise should indicate yet again why all the discussions and debate in China and the US – about whether or not China should continue financing the US fiscal deficit – are wholly beside the point, as I have been arguing almost monomaniacally for years. China cannot finance the US fiscal deficit, nor can any other country. China can only finance the US trade deficit, and it must do so by recycling its current account surplus, either via Chinese investors, or via central bank purchases of US dollar assets.

If there are hot money outflows from China large enough to cause the central bank to lose reserves, the central bank will not only stop buying US Treasury bonds and/or other dollar assets, it will have to sell something, which is most likely to be US dollar bonds. It has no choice.

Chinese investors who have taken money out of the country, on the other hand, will now effectively be responsible for recycling the Chinese current account surplus. They might decide to buy US Treasury bonds (and I suspect indirectly and directly many will), but they could also choose to buy gold, Venezuelan bolivares, Moroccan real estate, or in fact anything else they choose, and it is their buying that will determine how the Chinese trade surplus gets allocated among China’s trading partners.

The other point to consider in all this is the impact on Chinese monetary conditions. A net outflow from the central bank has to be financed by retiring central bank bills or “destroying” RMB. This implies monetary contraction, and it is still difficult for me to see how this would not have a contractionary effect on underlying money.

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.